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Wednesday, September 26, 2007

Mishkin: Will Monetary Policy Become More of a Science?

Federal Reserve Governor Frederic Mishkin reviews the progress economists have made in monetary theory and policy in recent decades, and he outlines nine key principles that successful central banks have incorporated into their policymaking activities. This won't be for everyone, the original is fairly long, and even the cut-down version below remains lengthy, but if you are interested in monetary policy this is a very nice summary of theoretical and empirical advances in recent decades, and where the literature is headed next:

Will Monetary Policy Become More of a Science?, by Frederic S. Mishkin, Board of Governors of the Federal Reserve System: Over the past three decades, we have seen a remarkable change in the performance of monetary policy. By the end of the 1970s, inflation had risen to very high levels, with many countries in the Organisation for Economic Co-operation and Development (OECD) experiencing double-digit inflation rates (figure 1).


Most OECD countries today have inflation rates around the 2 percent level, which is consistent with what most economists see as price stability, and the volatility of inflation has also fallen dramatically (figure 2).


One concern might be that the low and stable levels of inflation might have been achieved at the expense of higher volatility in output, but that is not what has occurred. Output volatility has also declined in most OECD countries (figure 3).


The improved performance of monetary policy has been associated with advances in the science of monetary policy, that is, a set of principles that have been developed from rigorous theory and empirical work that have come to guide the thinking of monetary policy practitioners.

In this paper, I will review the progress that the science of monetary policy has made over recent decades. In my view, this progress has significantly expanded the degree to which the practice of monetary policy reflects the application of a core set of "scientific" principles. Does this progress mean that, as Keynes put it, monetary policy will become as boring as dentistry i.e., that policy will be reduced to the routine application of core principles, much like filling cavities?[1] I will argue that there remains, and will likely always remain, elements of art in the conduct of monetary policy; in other words, substantial judgment will always be needed to achieve desirable outcomes on both the inflation and employment fronts.

I. Advances in the Science of Monetary Policy in Recent Decades Over the last five decades, monetary economists have developed a set of basic scientific principles, derived from theory and empirical evidence, that now guide thinking at almost all central banks and explain much of the success in the conduct of monetary policy. I will outline my views on the key principles and how they were developed over the last fifty or so years. The principles are: 1) inflation is always and everywhere a monetary phenomenon; 2) price stability has important benefits; 3) there is no long-run tradeoff between unemployment and inflation; 4) expectations play a crucial role in the determination of inflation and in the transmission of monetary policy to the macroeconomy; 5) real interest rates need to rise with higher inflation, i.e., the Taylor Principle; 6) monetary policy is subject to the time-inconsistency problem; 7) central bank independence helps improve the efficiency of monetary policy; 8) commitment to a strong nominal anchor is central to producing good monetary policy outcomes; and 9) financial frictions play an important role in business cycles. I will examine each principle in turn.

1. Inflation is Always and Everywhere a Monetary Phenomenon By the 1950s and 1960s, the majority of macroeconomists had converged on a consensus view of macroeconomic fluctuations that downplayed the role of monetary factors. Much of this consensus reflected the aftermath of the Great Depression and Keynes' seminal The General Theory of Employment, Interest, and Prices, which emphasized shortfalls in aggregate demand as the source of the Great Depression and the role of fiscal factors as possible remedies. In contrast, research by Milton Friedman and others in what became known as the "monetarist" tradition (Friedman and Meiselman, 1963; Friedman and Schwartz, 1963a,b) attributed much of the economic malaise of the Depression to poor monetary policy decisions and more generally argued that the growth in the money supply was a key determinant of aggregate economic activity and, particularly, inflation. Over time, this research, as well as Friedman's predictions that expansionary monetary policy in the 1960s would lead to high inflation and high interest rates (Friedman, 1968), had a major impact on the economics profession, with almost all economists eventually coming to agree with the Friedman's famous adage, "Inflation is always and everywhere a monetary phenomenon" (Friedman 1963, p. 17), as long as inflation is referring to a sustained increase in the price level (e.g., Mishkin, 2007a).

General agreement with Friedman's adage did not mean that all economists subscribed to the view that the money growth was the most informative piece of information about inflation, but rather that the ultimate source of inflation was overly expansionary monetary policy. In particular, an important imprint of this line of thought was that central bankers came to recognize that keeping inflation under control was their responsibility.[2]

2. The Benefits of Price Stability With the rise of inflation in the 1960s and 1970s, economists, and also the public and politicians, began to discuss the high costs of inflation (for example, see the surveys in Fischer, 1993; and Anderson and Gruen, 1995). High inflation undermines the role of money as a medium of exchange by acting as a tax on cash holdings. On top of this, a high-inflation environment leads to overinvestment in the financial sector, which expands to help individuals and businesses escape some of the costs of inflation (English, 1996). Inflation leads to uncertainty about relative prices and the future price level, making it harder for firms and individuals to make appropriate decisions, thereby decreasing economic efficiency (Lucas, 1972; Briault, 1995). The interaction of the tax system and inflation also increases distortions that adversely affect economic activity (Feldstein, 1997). Unanticipated inflation causes redistributions of wealth, and, to the extent that high inflation tends to be associated with volatile inflation, these distortions may boost the costs of borrowing. Finally, some households undoubtedly do not fully understand the implications of a general trend in prices that is, they may suffer from nominal illusion making financial planning more difficult.[3] The total effect of these distortions became more fully appreciated over the course of the 1970s, and the recognition of the high costs of inflation led to the view that low and stable inflation can increase the level of resources productively employed in the economy.[4,5]

3. No Long-Run Tradeoff Between Unemployment and Inflation A paper published in 1960 by Paul Samuelson and Robert Solow argued that work by A.W. Phillips (1958), which became known as the Phillips curve, suggested that there was a long-run tradeoff between unemployment and inflation and that this tradeoff should be exploited. Under this view, the policymaker would have to choose between two competing goals - inflation and unemployment - and decide how high an inflation rate he or she would be willing to accept to attain a lower unemployment rate. Indeed, Samuelson and Solow even mentioned that a nonperfectionist goal of a 3 percent unemployment rate could be achieved at what they considered to be a not-too-high inflation rate of 4 percent to 5 percent per year. This thinking was influential, and probably contributed to monetary and fiscal policy activism aimed at bringing the economy to levels of employment that, with hindsight, were not sustainable. Indeed, the economic record from the late 1960s through the 1970s was not a happy one: Inflation accelerated, with the inflation rate in the United States and other industrialized countries eventually climbing above 10 percent in the 1970s, leading to what has been dubbed "The Great Inflation."

The tradeoff suggested by Samuelson and Solow was hotly contested by Milton Friedman (1968) and Edmund Phelps (1968), who independently argued that there was no long-run tradeoff between unemployment and the inflation rate: Rather, the economy would gravitate to some natural rate of unemployment in the long run no matter what the rate of inflation was. In other words, the long-run Phillips curve would be vertical, and attempts to lower unemployment below the natural rate would result only in higher inflation. The Friedman-Phelps natural rate hypothesis was immediately influential and fairly quickly began to be incorporated in formal econometric models.

Given the probable role that the attempt to exploit a long-run Phillips curve tradeoff had in the "Great Inflation," central bankers have been well served by adopting the natural rate, or no-long-run-tradeoff, view. Of course, the earlier discussion of the benefits of price stability suggests a long-run tradeoff but not of the Phillips curve type. Rather, low inflation likely contributes to improved efficiency and hence higher employment in the long run.

4. The Crucial Role of Expectations A key aspect of the Friedman-Phelps natural rate hypothesis was that sustained inflation may initially confuse firms and households, but in the long run sustained inflation would not boost employment because expectations of inflation would adjust to any sustained rate of increase in prices. Starting in the early 1970s, the rational expectations revolution, launched in a series of papers by Robert Lucas (1972, 1973, and 1976), took this reasoning a step further and demonstrated that the public and the markets' expectations of policy actions have important effects on almost every sector of the economy.[6] The theory of rational expectations emphasized that economic agents should be driven by optimizing behavior, and therefore their expectations of future variables should be optimal forecasts (the best guess of the future) using all available information. Because the optimizing behavior posited by rational expectations indicates that expectations should respond immediately to new information, rational expectations suggests that the long run might be quite short, so that attempting to lower unemployment below the natural rate could lead to higher inflation very quickly.

A fundamental insight of the rational expectations revolution is that expectations about future monetary policy have an important impact on the evolution of economic activity. As a result, the systematic component of policymakers' actions, i.e., the component that can be anticipated, plays a crucial role in the conduct of monetary policy. Indeed, the management of expectations about future policy has become a central element of monetary theory, as emphasized in the recent synthesis of Michael Woodford (2003).[7] And this insight has
far-reaching implications, for example, with regard to the types of systematic behavior by policymakers that are likely to be conducive to macroeconomic stability and growth.[8]

5. The Taylor Principle The recognition that economic outcomes depend on expectations of monetary policy suggests that policy evaluation requires the comparison of economic performance under different monetary policy rules.[9] One type of rule that has received enormous attention in the literature is the Taylor rule (Taylor, 1993a), which describes monetary policy as setting an overnight bank rate (federal funds rate in the United States) in response to the deviation of inflation from its desired level or target (the inflation gap) and the deviation of output from its natural rate level (the output gap).[10] Taylor (1993a) emphasized that a rule of this type had desirable properties and in particular would stabilize inflation only if the coefficient on the inflation gap exceeded unity. This conclusion came to be known as the "Taylor principle" (Woodford, 2001) and can be described most simply by saying that stabilizing monetary policy must raise the nominal interest rate by more than the rise in inflation. In other words, inflation will remain under control only if real interest rates rise in response to a rise in inflation. Although, the Taylor principle now seems pretty obvious, estimates of Taylor rules, such as those by Clarida, Gali, and Gertler (1998), indicate that during the late 1960s and 1970s many central banks, including the Federal Reserve, violated the Taylor principle, resulting in the "Great Inflation" that so many countries experienced during this period.[11] Indeed, as inflation rose in the United States, real interest rates fell.[12]

6. The Time-Inconsistency Problem Another important development in the science of monetary policy that emanated from the rational expectations revolutions was the discovery of the importance of the time-inconsistency problem in papers by Kydland and Prescott (1977), Calvo (1978), and Barro and Gordon (1983). The time-inconsistency problem can arise if monetary policy conducted on a discretionary, day-by-day basis leads to worse long-run outcomes than could be achieved by committing to a policy rule. In particular, policymakers may find it tempting to exploit a short-run Phillips curve tradeoff between inflation and employment; but private agents, cognizant of this temptation, will adjust expectations to anticipate the expansionary policy, so that it will result only in higher inflation with no short-run increase in employment In other words, without a commitment mechanism, monetary policy makers may find themselves unable to consistently follow an optimal plan over time; the optimal plan can be time-inconsistent and so will soon be abandoned. The notion of time-inconsistency has led to a number of important insights regarding central bank behavior such as the importance of reputation (formalized in the concept of reputational equilibria) and institutional design.

7. Central Bank Independence Indeed, the potential problem of time-inconsistency has led to a great deal of research that examines the importance of institutional features that can give central bankers the commitment mechanisms they need to pursue low inflation. Perhaps the most significant has been research showing that central bank independence, at least along some dimensions, is likely very important to maintaining low inflation. Allowing central banks to be instrument independent, i.e., to control the setting of monetary policy instruments, can help insulate them from short-run pressures to exploit the Phillips-curve tradeoff between employment and inflation and thus avoid the time-inconsistency problem.[13]

Evidence supports the conjecture that macroeconomic performance is improved when central banks are more independent. When central banks in industrialized countries are ranked from least legally independent to most legally independent, the inflation performance is found to be the best for countries with the most independent central banks (Alesina and Summers, 1993; Cukierman, 1993; Fischer, 1994; and the surveys in Forder, 2000, and Cukierman, 2006).


A particularly interesting example occurred with the granting of instrument independence to the Bank of England in May of 1997 (Mishkin and Posen, 1997; Bernanke and others, 1999); before that date, the Chancellor of the Exchequer (the finance minister) set the monetary policy instrument, not the Bank of England. As figure 4 illustrates, during 1995-96 the U.K. retail inflation rate (RPIX) was fairly close to 3 percent, but the spread between nominal and indexed bond yieldsreferred to as 10-year breakeven inflationwas substantially higher, in the range of 4 percent to 5 percent, reflecting investors' inflation expectations as well as compensation for perceived inflation risk at a 10-year horizon. Notably, breakeven inflation declined markedly on the day that the government announced the Bank of England's independence and has remained substantially lower ever since. This case study provides a striking example of the benefits of instrument independence.

Although there is a strong case for instrument independence, the same is not true for goal independence, the ability of the central bank to set its own goals for monetary policy.[14] In a democracy, the public exercises control over government actions, and policymakers are accountable, which requires that the goals of monetary policy be set by the elected government. Although basic democratic principles argue for the government setting the goals of monetary policy, the question of whether it should set goals for the short-run or intermediate-run is more controversial. For example, an arrangement in which the government set a short-run inflation or exchange rate target that was changed every month or every quarter could easily lead to a serious time-inconsistency problem in which short-run objectives would dominate. In practice, however, this problem does not appear to be severe because, for example, in many countries in which the government sets the annual inflation target, the target is rarely changed once price stability is achieved. Even though, in theory, governments could manipulate monetary policy goals to pursue short-run objectives, they usually do not if the goal-setting process is highly transparent.

However, the length of the lags from monetary policy to inflation is a technical issue that the central bank is well placed to determine. Thus, for example, deciding how long it should take for inflation to return to a long-run goal necessarily requires judgment and expertise regarding the nature of the inflation process and its interaction with real activity. That need for judgment and expertise argues for having the central bank set medium-term goals because the speed with which it can achieve them depends on the lags of monetary policy. Whether the central bank or the government should set medium-term inflation targets is therefore an open question.

8. Commitment to a Nominal Anchor The inability of monetary policy to boost employment in the long run, the importance of expectations, the benefits of price stability, and the time-inconsistency problem are the reasons that commitment to a nominal anchor i.e., stabilization of a nominal variable such as the inflation rate, the money supply, or an exchange rate, is crucial to successful monetary policy outcomes.

An institutional commitment to price stability via establishing a nominal anchor provides a counterbalance to the time-inconsistency problem because it makes it clear that the central bank must focus on the long-run and thus resist the temptation to pursue short-run expansionary policies that are inconsistent with the nominal anchor. Commitment to a nominal anchor can also encourage the government to be more fiscally responsible, which also supports price stability. For example, persistent fiscal imbalances have, in the absence of a strong nominal anchor, led some governments, particularly in less-developed economies, to resort to the so-called inflation tax the issuing/printing of money to pay for goods and services that leads to more inflation and is thus inconsistent with price stability.

Commitment to a nominal anchor also leads to policy actions that promote price stability, which helps promote economic efficiency and growth. The commitment to a nominal anchor helps stabilize inflation expectations, which reduce the likelihood of "inflation scares," in which expected inflation and interest rates shoot up (Goodfriend, 1993). Inflation scares lead to bad economic outcomes because the rise in inflation expectations leads not only to higher actual inflation but also to monetary policy tightening to get inflation back under control that often results in large declines in economic activity. Commitment to a nominal anchor is therefore a crucial element in the successful management of expectations; and it is a key feature of recent theory on optimal monetary policy, referred to as the new-neoclassical (or new-Keynesian) synthesis (Goodfriend and King, 1997; Clarida, Gali, and Gertler, 1999; Woodford, 2003). A successful commitment to a nominal anchor has been found to produce not only more-stable inflation but lower volatility of output fluctuations ( Fatás, Mihov, and Rose, 2007; Mishkin and Schmidt-Hebbel, 2002, 2007).

9. Financial Frictions and the Business Cycle Research that outlined how asymmetric information could impede the efficient functioning of the financial system (Akerlof, 1970; Myers and Majluf, 1984; and Greenwald, Stiglitz, and Weiss, 1984) suggests an important link between business cycle fluctuations and financial frictions. When shocks to the financial system increase information asymmetry so that financial frictions increase dramatically, financial instability results, and the financial system is no longer able to channel funds to those with productive investment opportunities, with the result that the economy can experience a severe economic downturn (Mishkin, 1997). The rediscovery of Irving Fisher's (1933) paper on the Great Depression led to the recognition that financial instability played a central role in the collapse of economic activity during that period (Mishkin, 1978; Bernanke, 1983; and the survey in Calomiris, 1993), and it has spawned a large literature on the role of financial frictions in business cycle fluctuations (e.g., Bernanke and Gertler, 1999, 2001; Bernanke, Gertler, and Gilchrist, 1999; Kashyap and Stein, 1994). Indeed, it is now well understood that the most severe business cycle downturns are always associated with financial instability, not only in advanced countries but also in emerging-market countries (Mishkin, 1991, 1996). Minimizing output fluctuations thus requires that monetary policy factors in the impact of financial frictions on economic activity.

II. Advances in the Applied Science of Monetary Policy ...

III. The Art of Monetary Policy ...

IV. Further Advances to Make Monetary Policy More of a Science ...

V. Concluding Remarks

The science of monetary policy has come a long way over the past fifty years, and I would argue that its advances are an important reason for the policy successes that so many countries have been experiencing in recent years. Monetary policy will however never become as boring as dentistry. Monetary policy will always have elements of art as well as science. (That is good news because it will keep life interesting for monetary economists like me.) However, the advances in the science of monetary policy that I have described here suggest that monetary policy will become more of a science over time. Furthermore, even though art will always be a key element in the conduct of monetary policy, the more it is informed by good science, the more successful monetary policy will be.

    Posted by on Wednesday, September 26, 2007 at 09:45 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (11)


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